Paper Profits and Paper Wealth Explained in One Minute: Realized vs. Unrealized Gains
If you have ever invested in stocks, bonds, real estate, or any other asset, you may have wondered how to measure your wealth. How do you know if you are making money or losing money on your investments? And when do you actually get to enjoy your profits?
The answer depends on whether you are looking at paper profits and paper wealth, or realized profits and real wealth.
Paper profits and paper wealth are the theoretical gains or losses that you would have if you sold your assets at their current market prices. They are also called unrealized profits and unrealized losses, because they are not yet confirmed by a transaction. Paper profits and paper wealth only exist on paper, or on your balance sheet, and they can change as the market fluctuates.
For example, suppose you bought 100 shares of ABC company for $10 each, for a total cost of $1,000. A year later, the share price has risen to $15, so your investment is now worth $1,500. You have a paper profit of $500, or 50%, on your investment. But this profit is not yours until you sell your shares. If the share price drops to $8 before you sell, you will have a paper loss of $200, or 20%, on your investment.
Realized profits and real wealth are the actual gains or losses that you have after you sell your assets and receive cash. They are also called realized gains and realized losses, because they are confirmed by a transaction. Realized profits and real wealth are yours to keep, and they do not change as the market fluctuates.
Continuing with the previous example, suppose you decide to sell your 100 shares of ABC company when the share price is $15. You will receive $1,500 in cash, minus any fees or commissions. You have a realized profit of $500, or 50%, on your investment. This profit is yours to spend, save, or reinvest as you wish. It does not matter what happens to the share price after you sell. You have locked in your profit.
Why does this distinction matter? Because paper profits and paper wealth can be misleading indicators of your financial situation. They can make you feel richer or poorer than you really are, and influence your decisions accordingly. For example:
- Some investors may hold on to paper profits because they believe the asset will continue to appreciate in value. Alternatively, they may hold the asset for tax purposes, hoping to push any tax burden into the next tax year. The investor may also hold the asset to turn short-term capital gains into long-term capital gains1.
- Some investors may hold on to paper losses because they hope for a rebound in the asset value to recoup some or all of their losses. Holders of paper losses also consider tax treatment before realizing losses1.
- Some investors may experience emotional stress or euphoria from watching their paper profits and losses fluctuate with the market. This can affect their risk tolerance and investment strategy.
- Some investors may base their spending or borrowing decisions on their paper wealth, rather than their real wealth. For example, during the dot-com boom, many “paper millionaires” were created from restricted stock or options that they could not sell yet1. Some of them spent lavishly or took out loans based on their paper wealth, only to see it evaporate when the market crashed.
The bottom line is that paper profits and paper wealth are not real until you sell your assets and receive cash. Until then, they are only potential gains or losses that depend on the market conditions. Realized profits and real wealth are what matter in the end, because they reflect your actual financial situation.
I hope this blog post helps you understand the difference between paper profits and paper wealth, and realized profits and real wealth. If you have any questions or feedback, please let me know in the comments section below. Thank you for reading! 😊
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